Playing Canadian Banks Right Now

Editor's note: Read the latest on how the coronavirus is rattling the markets and what you can do to navigate it.

Ruth Saldanha: Investors have closely watched Canadian banks' second quarter results for clues on a path recovery out of the COVID-19 lockdown. Expectedly, all the major banks have increased their provisioning, and most seemed well set to deal with the impact of the virus. How should you play Canadian banks right now and what are our top picks? Morningstar analyst Eric Compton is here today to discuss this.

Eric, thank you so much for being here today.

Eric Compton: Thanks for having me.

Saldanha: How did you read the results for the major Canadian banks? Were there any surprises as far as you were concerned?

Compton: Yeah. So, I mean, obviously, results on the surface definitely weren't pretty. EPS was down between 30% and 70% for all the banks. There was no hiding from the increase in credit costs, which you called out in your intro. So, that was really the big story is, how bad are credit costs going to be. I'll say it wasn't a surprise that credit costs were high. I think everyone was kind of expecting that. But really the key question is, how bad are they going to get and are they manageable. And I would say based on Q1 results, they weren't pretty, but at least for now, credit costs do appear manageable. Management commentary on all the calls, they are running a lot of severely adverse scenarios in the background and all management teams across the board were saying that even under severely adverse scenarios they expect to maintain adequate capital levels. So, I would say, no surprises, not pretty, but so far things appear manageable, I think, is my key takeaway from Q1.

Saldanha: Do, you expect a slowdown to continue going ahead into the next quarter, maybe even more?

Compton: We aren't out of the woods yet as far as where we are economically. We think you're not going to really start to see even the beginning of a recovery until the second half of the year. So, some of the numbers have started to bottom out, some things like payments volumes, you've seen some of the manufacturing numbers, for example, they have shown – they do have appeared to have hit a bottom. But we think you are going to start to see the start of a recovery in the second half, which will be in kind of those Q3 results for the Canadian banks. But it's not going to be – we're not going to be back to 100% by the end of Q3 or even the end of Q4. So, we think relative to where we were pre-COVID-19, things will still be recovering even for the rest of the year and also into 2021, we think.

Saldanha: What are some of the risks that Canadian investors should watch for?

Compton: Yeah. So, obviously, one of the big risks is just exposures to some of the higher-risk industries. And so, I would call out energy exposure is going to be one that a lot of people are worried about. There's definitely increased risk in the energy sector right now just due to the collapse in oil prices. They have come back a little bit but still not back to where they were. So, I think there's going to be some pain there. So far, I mean, all the banks updated their energy disclosures for Q2 results, and I would say, exposures there appear quite manageable. I don't think energy loans are going to break any of the Canadian banks.

The other areas that were highlighted in many of the disclosures and on the calls were just industries that are directly affected by the economic shutdowns from COVID-19. And so, that's going to be things like restaurants, different retail exposures or if you are lining to airlines, things like that. So, almost all the banks provided more detail on that. There was one exception unfortunately. But based on the disclosures we have, those exposures also appear, I would say, relatively manageable. Some banks had more than others. But those sectors would be something to watch. That would be a risk I would call out.

Another thing I would say is just the Canadian consumer was generally more indebted than the U.S. consumer, for example, going into this. So, just paying attention to the health of the Canadian consumer and then how that potentially feeds into the real estate market would be another thing to pay attention to. So, energy, COVID-19-specific and then, just the health of the consumer and how that feeds into the real estate markets.

Saldanha: Finally, what's your top Canadian bank pick right now?

Compton: Yeah. So, if you would have asked me this a couple of weeks ago, it probably would have been easier. It would have been just National Bank of Canada. They were one of the most undervalued names on my list. They don't have outsized exposure to the housing industry in the hottest markets. But I guess you could say fortunately if you owned the stock, it's run up quite a bit. So, it's no longer one of the more undervalued names on my list.

So, today, I would take a closer look at Toronto-Dominion and also the Canadian Imperial Bank of Commerce. So, CIBC, yeah, they have the largest housing exposure among the Canadian banks. So, if you are really worried about that, probably stay away. But right now, my base case is that we're not going to have a housing crisis in Canada. So, I don't think that's going to hurt them too bad. You combine that with the fact that they are one of the most undervalued names on my list. So, I like them. And then, Toronto-Dominion, they are just historically one of the better banking franchises in Canada. They've got manageable energy exposures. Historically, they've been a good underwriter. I think you combine that with the valuation, and I think Toronto-Dominion would also be worth a closer look.

Saldanha: Thank you so much for joining us today, Eric.

Compton: Thanks for having me.

Saldanha: For Morningstar, I'm Ruth Saldanha.